California’s State Legislature passed legislation last week that imposes new mandatory penalties on corporations that underreport their tax liabilities and enacted a variety of other provisions. A.B. 1452 and S.B.28x. The legislation was signed by Gov. Arnold Schwarzenegger (R) on October 1st as the State was already 93 days into the fiscal year and desperate for a budget plan. The most egregious portion of the bills is a penalty that imposes a mandatory 20 percent penalty on corporations that underreport their tax by more than $1.0 million. Other provisions of the legislation provide some corporate tax relief, including changes to net operating loss (NOL) carryforward and carryback provisions, assignment of credits within combined returns, and limitations on the amount of tax liability that may be offset by tax credits.
New Mandatory Penalties
Just when it seems like corporations are recovering from the 2005 “amnesty” penalty (applied for tax years beginning before January 1, 2003), the California legislature delivered yet another “gift” to California corporate taxpayers. Unlike the previous amnesty penalty that applied to both corporate income tax and sales and use taxes, the new underreporting penalty only applies to corporate income tax. S.B. 28x enacts Cal. Rev. & Tax Code Sec. 19138 which provides that corporations with an understatement of tax in excess of $1.0 million will be subject to a 20 percent mandatory penalty based on the amount of the understatement. The penalty applies to any understatement in excess of $1.0 million that is reflected on an original or amended return for any taxable year beginning on or after January 1, 2003. For example, if a corporation is under audit for federal income tax purposes and anticipates that it may have a change in its federal taxable income that will result in an increase in California corporate income tax, this amendment will result in a 20 percent California penalty for underreporting tax. If the corporation is under federal audit for multiple years, the California penalty will apply to each year for which there is an understatement of tax. In order to avoid the underreporting penalty, corporations can file an amended return on or before May 31, 2009 that reflects the corrected (or projected) tax for that period.
The penalty is mandatory. However, the Franchise Tax Board (FTB) will not impose a penalty if the understatement is attributed to a change in law or the taxpayer’s reliance on a Chief Counsel ruling. The penalty is calculated based on the understatement of estimated tax. For corporations that file a combined return, the $1.0 million threshold is applied to the aggregate amount of tax liability for all members of the combined group. The underreporting penalty is in addition to all other penalties that may be imposed by the FTB – accuracy-related penalty, negligence, substantial understatement and any other applicable penalty.
The enactment of this new mandatory underreporting penalty forces taxpayers to consider their prior period filing positions and evaluate whether an amended return (and additional tax) should be filed (and paid) in order to avoid a mandatory and unwaivable 20 percent penalty. Doing so will require consideration of a contemporaneous refund claim to recover the amount of tax paid that is not ultimately owed. This strategy will create a signficant burden on taxpayers and the FTB. Taxpayers who are currently under audit, or are regularly audited by the IRS or the California FTB or have transactions or tax filing positions that are susceptible to challenge (e.g., business/nonbusiness income, sales factor sourcing, etc.) should consider estimating the magnitude of tax associated with these issues in order to assess the potential penalty amount.
Taxpayers must also assess the impact of the penalty on their FIN 48 reserves, subject to the U.S. Constitutional concerns discussed below.
Sutherland Observation: The enactment of the penalty may be equated to a retroactive tax. By enacting retroactive tax legislation that imposes penalties for the previous five tax years, California runs a significant risk of inciting a constitutional challenge. The United States Supreme Court has repeatedly upheld retroactive tax legislation (which could also include retroactive penalties) against a Due Process challenge when the retroactive application of a statute is supported by a legitimate legislative purpose and rational means. In the leading Supreme Court case addressing retroactivity, U.S. v. Carlton, 512 U.S. 26 (1994), the Court held that a one year retroactive tax provision did not violate Due Process because the statutory amendment was a correction of a mistake in the original provision. Thus, while a one year retroactive tax was upheld, it is unclear how many years of retroactivity the Court will allow. While it is possible that two or three years of retroactivity may be allowed, five years of retroactivity is susceptible to challenge. Therefore, it is likely that California will face a Due Process Clause challenge to its penalty provisions.
In addition, it is worth noting that the 2005 California amnesty penalty, which imposed a 50 percent penalty on taxpayers who failed or declined to participate in the amnesty program, was challenged in General Electric Co. v. FTB, Cal. Ct. App., No A115530 (dismissed July 13, 2007). The superior court held that the case was not ripe for judicial review because the tax years at issue were still in protest status and the amnesty penalty had not yet been imposed. Other taxpayers are challenging the 2005 amnesty penalty. A challenge to the current mandatory underreporting penalties may have to wait until there is a proposed assessment of tax and imposition of the penalty by the FTB. Nevertheless, taxpayers should consider the Constitutional issues in determining whether to adjust FIN 48 reserves associated with the penalty.
Net Operating Losses: They Taketh Away and Giveth
Similar to the suspension of NOLs that occurred in California in 2002 and 2003, California has once again suspended use of corporate NOL carryforwards. A.B. 1452 provides for suspension of NOL carryforwards for tax years beginning on or after January 1, 2008, and before January 1, 2010 (i.e., 2008 and 2009 tax years). However, to soften the blow, California has extended its NOL carryover period from 10 years to 20 years for NOLs generated in tax years beginning on or after January 1, 2008.
In addition, California, like many other states, has not historically permitted NOL carrybacks. However, A.B. 1452 now permits corporations to carryback NOLs attributable to taxable years beginning on or after January 1, 2011. While this provision would seem like a nice win for corporations, the delayed effective date of this provision may leave many wondering whether another California financial crisis will justify a premature repeal of the carryback provision.
Application of Combined Credits
Unitary corporations filing a combined return in California scored a significant victory in A.B. 1452 which provides for tax years beginning on or after July 1, 2008. Corporations may assign “eligible tax credits” to other members of the unitary group. Once assigned, the credit is irrevocable and may only be applied to reduce tax in tax years beginning on or after January 1, 2010. An “eligible credit” is any credit earned by the taxpayer in a tax year beginning on or after July 1, 2008, or any credit earned in any taxable year beginning before July 1, 2008, that is eligible to be carried forward to the taxpayer’s first taxable year beginning on or after July 1, 2008.
Sutherland Observation: The application of tax credits in a unitary group was recently litigated in General Motors Corp. v. FTB, 139 P. 3d 1183 (Cal. Sup. Ct., Aug. 18, 2006). In General Motors, the California Supreme Court held that credits could only be used by the member that generated them.
California’s recent legislative change that now allows assignment of credits to other members of a unitary group essentially overturns the holding in General Motors (at least as applied to credits). The holding in General Motors raised constitutional concerns because it provided for a limitation of tax attributes to individual members of a unitary group while requiring that every group member’s income be included in the tax base.
In addition to the aforementioned changes, A.B. 1452 and S.B. 28x also provide for the enactment of the following provisions – all of which are primarily geared at generating immediate tax revenue for California:
- Acceleration of the due date for limited liability company fees from April 15th of the subsequent year to June 15th of the current taxable year. The effect of this provision is that taxpayers have two payments in 2009 – one for their 2008 return, and one for the 2009 return.
- Increase in quarterly estimated tax payments for the first and second installments from 25 percent to 30 percent. The third and fourth installments drop from 25 percent to 20 percent.
- Restriction on amount of business credit that can be applied against a corporation’s tax liability for tax years beginning in 2008 and 2009 to 50 percent of the net tax calculated before credits.